Financing Focus

Looking for Leverage

Help clients determine funding sources for small multifamily investments.

By Joseph Mardesich |

Small apartment properties can be an excellent way for first-time investors to enter the commercial real estate market. Apartment properties with between five and 50 units are attractive investments because there is less competition for them. Buildings with five and more units are outside owner-occupied buyers' comfort zones and yet, large investors and institutional investors tend to ignore these properties. Add to this the fact that there are many more small properties than large ones, it is clear that the opportunity to find undiscovered bargains is great in the small-apartment arena.

However, a major problem is that maximum leverage, which is more critical for small investors because of their limited resources, is increasingly difficult to obtain in today's market. Though many lenders technically permit up to 80 percent loan to value, financing amounts often are limited to far below that level. This is because loan amounts not only are restricted by LTV ratios, but also by debt service coverage ratio requirements. In many markets today, capitalization rates are at historic lows, so DSC limits are kicking in before LTV ratios. Typically lenders require that properties' net operating incomes are at a ratio of 1.2 to 1 compared to debt service to provide highly leveraged financing.

Finding Financing

Seller Carrybacks. Some innovative lenders allow sellers to obtain mortgages that are not secured by the purchase property. Instead the mortgages are secured by another property the buyer owns and the debt service on the carryback is not included in the DSC ratio. For example, suppose a buyer puts 10 percent down on an investment property and obtains a new first mortgage of up to 80 percent LTV subject to 1.2 DSC ratio on the first mortgage only. The seller carries 10 percent against one of the buyer's other properties such as a small rental property, a commercial building, or even a home. In a case where the first mortgage may be limited to less than 80 percent LTV because of the DSC ratio, the seller's carryback is limited to 10 percent. This provides a buyer with up to 10 percent more leverage than otherwise would be possible.

Seller Contributions. Some lenders allow sellers to contribute up to 3 percent of the buyer's closing costs, thus reducing the buyer's need for cash. The seller contribution typically only is allowed to cover actual closing costs, such as points, appraisal fees, or title insurance. These funds typically cannot be used as a repair credit, which for underwriting purposes would reduce the purchase price by the amount of the credit.

Gifted Down Payment. A few lenders allow buyers to use a financial gift from a family member for up to half of the down payment on an investment. However, there are some restrictions. Specifically, the gift must be from an immediate family member - either a parent, child, or sibling. The gift funds must be verified via bank statements and/or a verification of deposit and the source of the gift funds must be documented via canceled checks and/or bank statements.

How does this process work? If a buyer is able to obtain an 80 percent first mortgage and a 10 percent down payment gift, he or she only needs 10 percent cash plus closing costs and required post-closing reserves, which can be as little as two months' principal, interest, taxes, and insurance, to purchase a property.

Mezzanine Financing. Mezzanine financing is finally available to the small-apartment purchaser for acquisitions as low as $1 million. Under these circumstances, a lender generally makes both the first and second loan. The first loan is limited to 80 percent LTV and a 1.2 DSC ratio. The combined LTV of the first and second loans is limited to 85 percent, with a combined DSC ratio of 1.07. Even in low cap-rate markets where the first mortgage may be limited to 65 percent LTV or less, the mezzanine loan typically can stretch a buyer's leverage up to 10 percent.

Equity Lines and Other Properties. When combined with a new first mortgage, an equity line or lines of credit against other properties a borrower owns is another way to obtain 100 percent of financing for an investment property. Even though the payments for such lines of credit are not included in the property's DSC ratio for underwriting purposes, the buyer should take into account how he or she will service this additional debt.

Negative Cash Flow Programs. Several lenders offer loans with DSC ratios of .90 or lower. In some instances buyers may be able to purchase a property with negative cash flow. However, purchasers must be able to verify that they have adequate income from employment or other sources. This is typically done via W-2 forms, paycheck stubs, and tax returns for the previous two years. A credit report also will be checked to verify a borrower's monthly debt obligations to establish that he or she has an adequate personal debt-to-income ratio when considering the negative cash flow obligation incurred by the subject property.

It's important that commercial real estate professionals carefully advise clients on their financing options for small-apartment properties. While some of the previous strategies may be perfect solutions for select clients, others may result in poor or negative cash flow if used imprudently. All investors must have a clear understanding of the pros and cons of any financing strategy before making a purchase decision.